What overdraft means
An overdraft is permission to spend money you do not have in your account, up to a limit.
The bank agrees a limit. You draw down as you need to, and you repay as receipts come in. Interest is charged on the amount actually overdrawn, day by day, so a business that only dips into it occasionally pays only for those days.
That flexibility is the attraction. It matches the shape of a working capital problem, where money goes out before it comes in and the shortfall varies week to week.
The critical term is that an overdraft is normally repayable on demand. That is not a formality. It means the bank can require repayment of the whole balance at any time, without a default having occurred, and without giving reasons. A business treating an overdraft as permanent capital has misunderstood what it holds.
How it is used
Overdrafts fund the gap, not the growth.
A distributor buying stock in advance of a selling season. A contractor funding materials before a stage payment arrives. A business covering payroll in a month when a large customer pays late.
The facility letter is where the terms live. It states the limit, the interest rate and how it is calculated, the fees, the security required, any covenants, the review date, and the demand provision.
Security is usual for anything substantial. A charge over company assets, a personal guarantee from the directors, or a lien over a fixed deposit. Small unsecured limits are available but modest.
Covenants can also bite. A facility may require the account to be brought into credit for a period each year, which prevents an overdraft becoming a permanent loan, and a business that never clears the balance is signalling that it needs different funding.
Review dates matter too. An overdraft renewed annually is renegotiated annually, and renewal is not guaranteed.
Key features
- A limit up to which an account may be overdrawn
- Interest charged on the daily overdrawn balance
- Normally repayable on demand, without default or reasons
- Usually secured by a charge, a guarantee or a lien on deposits
- Reviewed periodically, with renewal at the bank's discretion
- Suited to short term fluctuation rather than long term funding
How this works in Nigeria
Cost is the first practical point. Nigerian overdraft pricing is typically expressed as a spread over a reference rate, and in a high rate environment the all in cost is substantial. Fees are layered on top: facility or arrangement fees, management fees, and charges on renewal.
A business comparing an overdraft with other funding should calculate the total cost of what it will actually draw, not the headline rate, and should ask specifically what fees apply on drawdown and on renewal.
The demand feature is the second. Nigerian businesses have found facilities reduced or withdrawn during periods of monetary tightening, at exactly the moment they were most needed. Building a business model that depends on an overdraft remaining available is a real risk, and the mitigation is to keep the reliance modest and to have a second banking relationship.
The third is security. Directors are routinely asked for personal guarantees, which puts personal assets behind what looks like a company facility. That is a considered decision rather than a formality, and directors should ask for a cap and a defined release.
Unauthorised overdrafts, where an account goes into debit without an agreed limit, attract penal charges and should be avoided entirely.
Overdraft vs term loan
Two facilities for two different problems.
An overdraft is short term and fluctuating. You draw what you need, repay when receipts arrive, and pay interest only on the daily balance. It is repayable on demand, reviewed periodically, and the bank can withdraw it. Use it for working capital gaps.
A term loan is a fixed amount for a fixed period, repaid on an agreed schedule. It is not repayable on demand in the same way, so it gives certainty, and it usually carries a lower rate. Use it for equipment, expansion or anything with a defined payback.
The error businesses make is funding a long term need with an overdraft because it was easier to arrange. The facility is then never cleared, the bank asks why, and the business discovers it has been funding a permanent asset with money the bank can call in tomorrow.
Limits and risks
Repayable on demand is the fundamental limitation. It is not a committed facility, and the certainty a business needs for planning is not there.
Cost is the second. Interest plus arrangement, management and renewal fees make it one of the more expensive forms of borrowing available to a small business.
Security requirements can be disproportionate. A modest limit secured by an all assets debenture and personal guarantees ties up far more than it provides.
And it is easy to become dependent. A business that never clears the balance is using short term money for a long term purpose, and the correction, when the bank asks for it, arrives at a bad time.
Worth knowing
Never rely on an overdraft to fund something you cannot repay quickly. Repayable on demand means exactly that, and Nigerian businesses have had facilities reduced during tightening cycles at the precise moment the money was needed.
Questions people ask
What is an overdraft?
A facility allowing an account to be drawn below zero up to an agreed limit, with interest charged on the daily overdrawn balance. It is designed for short term fluctuations in working capital.
What does repayable on demand mean?
That the bank can require repayment of the whole balance at any time, without a default having occurred and without giving reasons. It is why an overdraft should not be treated as permanent funding.
How is overdraft interest calculated?
On the amount actually overdrawn, day by day, so you pay only for the days you use it. Arrangement, management and renewal fees are charged separately and should be included when comparing cost.
Do I need security for an overdraft?
For anything substantial, usually yes. A charge over company assets, a personal guarantee from directors, or a lien over a fixed deposit are common. Small unsecured limits exist but are modest.
What is the difference between an overdraft and a term loan?
An overdraft is short term, fluctuating and repayable on demand. A term loan is a fixed amount for a fixed period on an agreed repayment schedule, usually at a lower rate, and it gives certainty an overdraft does not.
Why does my bank want the account cleared each year?
A clean down covenant prevents an overdraft becoming permanent funding. A business that can never clear the balance is using short term money for a long term purpose and needs a different facility.